Foreign Exchange Basics

Forex Basics

1. What is Forex?

The foreign exchange (currency, forex or FX) spot market exists wherever one currency is traded for another. It is the largest financial market in the world, and is made up of Central Banks, International and Commercial Banks, Corporate’s, Hedge Funds and other currency speculators. The average daily turnover in the global forex markets is currently around US$ 4.0 trillion. Retail trade is now only a small fraction of this market and speculators have taken over.

All currencies are traded in pairs and each is assigned with an abbreviation. Here are some common currencies:

The rate at which currencies are exchanged for one another is called the currency exchange rate. For example, the “EUR/USD exchange rate is 1.4200” means that one EUR is exchanged for 1.4200 US Dollars. 

1.1 The purpose

Foreign exchange trading is undertaken for many different reasons. Some is for commercial purposes, payments for imports or converting export receipts. Corporate’s will be hedging capital flows and covering exchange risk of their offshore entities. Banks will be covering their commercial flows, corporate deals and trading for profits through their Treasury areas. Traders everywhere will try to generate profits, by speculating on whether a currency will rise or fall in value in comparison to another currency.

1.2 Global market

As of April 2010, the average daily turnover in foreign exchange markets had reached $4.0 trillion USD which is an increase of 20% from volumes traded in 2007 (BIS Survey figures). Market participants have put this down to the significant weakening of the USD in the last 12 months.

1.3 New Zealand Market

According to figures released by the RBNZ, the average daily turnover on New Zealand’s foreign exchange market  in 2010 was US$ 9.5 billion, relative to US$ 13 billion in 2007, US$ 7.5 billion in 2004 and US$ 4.2 billion in 2001. Of these figures, 62% of total turnover was in NZ/US dollar transactions, 8% was in AUD/USD and 6% was in EUR/USD. The total turnover is down 31% from 2007 which is due to a decrease in the foreign exchange swap transaction volume and a smaller cause was the fall in the NZD versus the USD.

2. How an FX trade works

The objective of currency trading is to exchange one currency for another in the expectation that the market rate or price will change so that the currency you bought increases in value relative to the one you sold.
Any foreign exchange transaction ultimately begins with two events:

• One currency has been purchased
• The other currency (of that pair) has been sold.

The currency that has been sold will need to be funded on a day-to-day basis and the currency purchased will earn interest.
After gaining an intuitive understanding of how exchange rates move, one can begin FX trading, thereby speculating on the exchange rate so as to potentially reap profits from the fluctuating value of currencies.
 

2.1 Going Long or Short

A long position is when a trader buys a currency at one price with the intention of selling it later at a higher price. In this scenario the trader will benefit from a rising market (price goes up) and must sell the currency back in order to lock in the profit. This is also referred to as the notion of “buy low, sell high” in other trading markets.

For example:

A trader believes that EUR/USD is moving higher and buys 10,000 EUR at 1.4200 (sells 14.200 USD). Assuming they are correct and the EUR/USD goes up to 1.4250/1.4253 they then decide to close the position: when you close a long position you sell the base currency (10,000 EUR in our example) and buy the quote currency (10,000*1.4250 = 14,250 USD):

A short position is one in which the trader sells a currency in anticipation that it will depreciate, and they can buy it back later at a lower price. Under this scenario the trader is looking for a ‘falling market’ and must buy the currency back in order to lock in the profit. This is the opposite of a long position.

For example:

A trader believes that GBP/USD is moving down and sells 10,000 GBP at 2.0400 (buys 20,400 USD). Assuming they are right and GBP/USD goes down to 2.0300/2.0305 and you decide to close the position: when you close a short position you buy the base currency (10,000 GBP in our example) and sell the quote currency (10,000*2.0305 = 20305 USD):

2.2 More Trading Technology

On our trading platform you will notice that there are two prices for each currency pair. Similar to all financial products, FX quotes include a ‘bid’ and ‘offer’ (also known as ‘ask’).
A bid price is the price that a buyer (Velocity Trade) is willing to pay to purchase a particular currency pair and where the counterparty (you) can sell that currency pair at a particular time.
An offer or ask price is the rate at which the seller (Velocity Trade) is willing to sell a particular currency pair and where the counterparty (you) can buy that currency pair at a particular time.
The bid/ask combination makes up a quotation, which is based on a floating exchange rate. For example, in the EUR/USD pair, the quote might be 1.4150/55.

3. Calculating Profit and Loss in Leveraged Trading

3.1 Pip

Sometimes also referred to as a ‘tick’ the term is used in currency markets to represent the smallest incremental move an exchange rate can make. Because the majority of exchange rates are quoted to the fourth decimal place, (i.e. EUR 1.3744/ NZD 0.7885) then a one ‘pip’ move would be 0.0001 to 1.3745 and 0.7886 respectively. The value of a ‘pip’ is not always the same and can differ per currency.

Here are some examples based on a currency amount of 100,000 units of the BASE currency:

3.2 Leverage

The most enticing aspect of trading Forex in the last 5 years is the high degree of leverage used.

Leverage is the degree to which a client or investor can use borrowed money. To enable them to do this they place an amount of money on deposit with a firm (‘margin’) and effectively borrow against this money. Leverage of 50/1 or 100/1 is common.

However, it comes with greater risk. If an investor uses leverage to make a currency trade and the position moves against the investor, his or her loss is much greater than it would’ve been if the investment had not been leveraged – leverage magnifies both gains and losses.

Leverage seems very attractive to those who are expecting to turn small amounts of money into large amounts in a short period of time. However, leverage can be a double-edged sword. It can magnify the losses as well as the gains. Most traders analyze the charts correctly and place sensible trades, yet they tend to over-leverage themselves (get in with a position that is too big for their portfolio). As a consequence they often end up forced to exit a position at the wrong time because they cannot meet a margin call or their positions have been closed out for them.

However, properly managed, leverage is a powerful tool and has been used successfully in equity markets over many years.

3.3 Margin Explanation

Margin Account

Is an account in which a company or brokerage firm involved lends the client (trader) cash with which to trade financial products. Unlike a normal cash account a margin account allows the client to trade these products with money that effectively he/she does not have.

Initial Margin

The initial or original amount required by the firm to be placed on deposit before the client can begin ‘trading’. This is normally a set standard amount i.e. $10,000 of the base currency they wish to trade in.

Variation Margin

The additional margin required to bring client accounts up to the required level due to fluctuations within the market. Also known as a ‘top-up’.

Margin Call

A call from the company to a client (trader) demanding the depositing of further monies to satisfy an in-house requirement and provide cover for an adverse price movement. With a trading platform clients are advised in advance that their initial margin is becoming too low to cover their existing positions and warned that a ‘top-up’ is required.

Close Out

Is the liquidating of a traders’ position(s) because that account holder failed to meet a variation margin or margin call.

Please note
As per the client agreement, the client will automatically be closed out of any positions if their positions fall below the 2% threshold.

3.4 Profiting from trades

You buy a currency if you expect the first-named currency to strengthen against the second-named currency, and you sell a currency if you expect the first-named currency to weaken against the second-named currency.

Example of making money by buying NZD’s:

Example of making money by selling NZD’s:

4. Other Key Concepts in Currency Trading

4.1 Interest Rollovers

For positions still open at “cut-off time” (usually 5pm New York EST), there is a daily rollover interest rate that the trader either pays or earns, depending on your established margin and position in the market. If you do not want to earn or pay interest on your potions, simply make sure they are all closed before 5pm EST, the established end of the market day.

Since every currency trade involves buying one currency and selling another then interest rollover charges are part of forex trading. Interest is paid on the currency that is sold (borrowed), and earned on the one that is bought. If a client is buying a currency with a higher interest rate than the one he/she has sold (borrowed), the net differential will be positive (i.e. USD/JPY)- and the client will earn interest as a result. Ask your client sales representative about specific details regarding rollover if you are unsure.

Rollover example

You are long 100,000 EUR/USD. The EUR/USD at rollover is trading at 1.1800. The EUR short-term interest rate is 2.25% and the USD short-term interest rate is 4.00%, the theoretical rollover calculation would be as follows:
Contract notional value x (base currency interest rate- quote currency interest rate) / 365 days per year x currency base currency rate = daily rollover interest debit/ credit

100,000 x (2.25% - 4.00%) / 365 x 1.1800 = daily rollover interest debit/credit

Further: 100,000 x -1.75% / 365 x 1.1800 = USD – $5.66 rollover debit to your account

Since you are long a base currency (EUR) bearing a lower interest rate than the quote currency (USD), you will pay for that rollover.

Likewise if you are long 100,000 NZD/JPY, the NZD/JPY at rollover is 89.50, NZD short-term interest rate is 1.25%, the theoretical rollover calculation would be as follows:

100,000 x (7.50% - 1.25%) / 365 x 89.50 = daily rollover interest debit/credit

Further: 100,000 x 6.25% / 365 x 89.50 = 1532 JPY or NZD 17.12 rollover credited to your account.

Since you are long a base currency (NZD) bearing a higher interest rate than the quote currency (JPY), you will earn interest for that rollover.

5. Type of Order

5.1 Market Order

A market order is an order to buy or sell a currency pair at the current market price. The advantage of a market order is you are almost always guaranteed your order will be executed (as long as there are willing buyers and sellers).

Since every currency trade involves buying one currency and selling another then interest rollover charges are part of forex trading. Interest is paid on the currency that is sold (borrowed), and earned on the one that is bought. If a client is buying a currency with a higher interest rate than the one he/she has sold (borrowed), the net differential will be positive (i.e. USD/JPY)- and the client will earn interest as a result. Ask your client sales representative about the specific details regarding rollover if you are unsure.

5.2 Limit Order (or Take Profit Order)

A limit order is an order tied to a specific position for the purpose of locking in the gains from that position. A limit order placed on a buy position is an order to sell. A limit order placed on a sell position is an order to buy. A limit order remains in effect until the position is liquidated or cancelled by the client.

For example, if a trader has an open position where he is long (meaning he has bought) EUR/USD at 1.4233. In such a scenario, a trader can place a limit order to determine at what rate he will close his position and take his profits. So, for instance, if the aforementioned trader was looking to capture 100 pips on the EUR/USD, he would place a limit order at 1.4333; if the market reached that rate, he would be taken out of the market, and his profit from the trade would immediately be reflected in his balance.

5.3 Stop Loss Order

A stop loss order (also stop order) is an order linked to a specific position to close that position and prevent additional losses. A stop-loss order placed on a long position will be an order to sell if the market continues to move lower. A stop-loss order placed on a short position will be an order to buy if the market continues to move higher. A stop-loss order remains in effect until the position is liquidated or cancelled by the client.

Stop-loss orders are one of the most highly recommended tools for traders. They are crucial to ensuring that the trader does not lose all the money with a dingle trade, and can be vital when establishing risk reward ratios to ensure that traders are not making foolish decisions.

For example, if a trader is long EUR/USD at 1.4200, he may wish to minimize the loss he is willing to accept by placing a stop loss order at 1.4170, in this case, if the market reached 1.4170, he would be closed out of the position and would have suffered a loss of about 30 pips.

5.4 Entry order

An Entry Order is an order to enter the market at a specified price.Entry orders are divided into two types, Limit Entry and Stop Entry orders.

a) Entry Limit Order: An order initiating an open position to sell as the market rises, or buys as the market falls. The client believes the market will reverse direction at the level of the order. Limit entry orders are often conducive to strategies pertaining to range-bound markets, where clients can place orders to buy at the bottom of the range and sell at the top.

b) Entry Stop Order: An order initiating an open position to sell as the market falls, or buys as the market rises. The client placing the order believes that prices will continue to move in the same direction as the previous momentum after hitting the order level.

5.5 Good until Cancelled (GTC)

A GTC order is an order to buy or sell at a specified price. This order remains open until filled or until the client cancels.

5.6 One Cancels the Other (OCO)

A stop-loss order and a limit order are linked to a specific position. One order, the stop, is to prevent additional loss on the position, and one order, the limit is to take profit on the position. When either order is executed, closing the position, the other order is automatically cancelled.

For example, a trader buys EUR/USD at 1.4200, looking for a long term move to 1.4250, however, they decide that if the EUR/USD moves below 1.4170 they will close out their position. So they put a limit order at 1.4250 and a stop order at 1.4170, when one order has been filled, the second order is automatically cancelled.

See our trader's dictionary for a full A-Z of trading terms >

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